When an Underwriter Becomes a Fiduciary to an Issuer

Underwriters, beware! First the WorldCom decision shook the underwriting world. Now the high court of New York, in EBC I, Inc. v. Goldman Sachs & Co., 2005 WL 1346859 (NY June 7, 2005), has given underwriters a new cause for concern in conducting public offerings. The court refused to dismiss, over a vigorous dissent, an issuer's claim for damages holding that an underwriter rendering advice to an issuer as to market conditions at the time of pricing a public offering may be deemed a fiduciary to the issuer. As a fiduciary, the underwriter would need to disclose to the issuer all material conflicts of interest involving its rendering of advice. As a consequence of the decision, underwriters should consider reexamining their underwriting agreements and disclosure practices.

In the typical firm commitment underwriting process, an investment bank, acting as an underwriter, negotiates with the issuer the offering price for the securities, purchases the securities from the issuer pursuant to an underwriting agreement at a discount, and resells them to the public at the public offering price. The difference or "spread" between the amount the underwriter pays for the securities and the public offering price makes up the underwriter's compensation for its services.

Customarily, the underwriting relationship between the issuer and the underwriter is understood to be embodied in the underwriting agreement and to be the product of an arm's length relationship where each party negotiates the public offering price for its own benefit, not for the benefit of the other party. However, according to the holding in EBC I, the underwriting relationship may take on the added dimension of a fiduciary relationship when the parties create a relationship of higher trust than would arise from the terms of the underwriting agreement alone. The parties may create a relationship of higher trust when the underwriter has been engaged to render expert advice and the issuer relies on this advice. Unlike in an arm's length relationship, in a fiduciary relationship, the underwriter is under a duty to act or to give advice for the benefit of the issuer.

In 1999, a high flying dotcom, eToys, now known as EBC I, Inc., retained Goldman Sachs & Co. ("Goldman") as a lead managing underwriter for its IPO. eToys and Goldman entered into an underwriting agreement which fixed the IPO price at $20 per share and Goldman's compensation at $1.35 per share or 6.75% of the IPO proceeds. In its first day of trading, eToys traded as high as $85 a share. eToys ultimately went bankrupt and the case was brought by its bankruptcy trustee.

Although it was not a part of their formal underwriting agreement, eToys alleged in its complaint it relied on Goldman's knowledge, expertise and integrity to advise it as to a fair IPO price. eToys also alleged that, unknown to eToys, Goldman entered into spinning and flipping arrangements with its customers who would purchase eToys securities from Goldman at the IPO price, resell such securities to other buyers subsequent to the IPO and kick back to Goldman 20% to 40% of their profits from such trading. The plaintiff alleged that because of Goldman's arrangement with its customers, a lower IPO price would result in a higher profit to these customers upon the resale of eToys securities and thus a higher kickback amount to Goldman. Accordingly, Goldman allegedly had an incentive to advise eToys to keep its IPO price lower than market forces dictated.

In response to Goldman's motion to dismiss the plaintiff's claim, the court concluded plaintiff's case may proceed. In the court's view, plaintiff's allegations, if true, evidenced an informal fiduciary relationship or, in other words, a relationship of higher trust beyond that which arises from their underwriting agreement alone because of eToy's confidence in, and reliance on, Goldman's "advice" concerning the IPO price. To the extent that underwriters function as "expert advisors" to their clients on market conditions, a fiduciary duty may exist. Under this fiduciary relationship, Goldman would be expected to disclose to eToys material conflicts of interest, such as its arrangements with its customers, when it rendered advice to eToys. According to the court majority, fiduciary liability is not dependent solely upon an agreement between the issuer and investment bank. Goldman "breached this duty by allegedly concealing from eToys its divided loyalty arising from its profit-sharing arrangements with clients."

The dissent attacked the majority for implying duties between sophisticated, well-represented commercial parties. As the dissent points out, "underpricing" is a common and well accepted capital markets practice that benefits issuers. The underwriting price is a key term of the underwriting agreement—a negotiated agreement—and was not "set" by Goldman. The dissent notes as well the active rulemaking of the NYSE and NASD to address allocation practices. The dissent would not have permitted plaintiff's "conclusory allegations" to survive a motion to dismiss.

The case is troubling because it may encourage issuers (or their successors in bankruptcy) to pursue claims tangential to the fundamental underwriting relationship of buyer and seller. This may add a costly layer of risk to the underwriting equation. By allowing the claim to survive, the court elevates the settlement value of any claim that there was something more than a mere underwriting relationship between the parties.

Several years ago, investment banks faced a similar threat from bankruptcy trustees in the context of failed acquisition transactions. In many respects, the allegations were much more powerful than in the underwriting context because the focus of merger and acquisition engagements is primarily expert advice. The industry response was to revise engagement letters to disclaim any fiduciary duty or other implied obligation beyond what the express terms of the engagement letter provides. A similar response can be expected to the EBC I decision. In fact, a number of underwriting firms have requested that issuers execute new provisions in underwriting agreements disclaiming an advisory or fiduciary relationship with the issuer.

Underwriters should review and, if necessary, revise their underwriting agreements and disclosure practices, and consider including disclaimers of any fiduciary duty to issuers.